The world must inflate or bust; Australia mustn't join in

Australia must decide whether or not to join the global inflation race, and it would be better in the long run if it didn’t.

The world’s central banks are overtly trying to increase inflation because it’s the only realistic solution for the world’s (still) excessive debt, and the Reserve Bank of Australia will soon have to decide whether to join in or bear down on inflation with relatively higher interest rates.

That was a key theme at the Australian Davos Connection’s Hayman Island leadership retreat over the past weekend.

There is still too much debt in the world, and it’s not coming down. The main central banks have all separately, or perhaps collectively, decided that the only way to deal with it is to inflate the debt away – that is, by debauching the value of money, a tried and trusted technique.

“It’s inflate or bust,” said one conference panellist from Europe. “You can’t solve the problem of too much debt with low interest rates designed to encourage more debt. It won’t work.”

Australia’s dilemma in this environment is becoming acute: to go for short-term growth with the prospect of an over-heated housing market, or long-term stability with lower growth and inflation.

And this on the eve of the G20 meeting in Brisbane, at which the world’s political leaders will pledge to go for growth -- 2 per cent above the IMF’s base line forecast for the next five years. They won’t talk about inflation, but that is the subtext. Growth and inflation are the only way the world’s debt will be dealt with.

There was a consensus at the Hayman conference that Europe is the world’s economic trouble spot. Most European banks are insolvent and will eventually have to write off billions of euros worth of bad loans.

And the problem is that the business cycle is closely tied to the credit cycle: when banks start to deleverage, non-performing loans start to blow out because a retrenchment in lending and tightening credit standards leads to problems among over-extended borrowers.

It was clear from several sessions at the conference that the greatest danger to the world lies in Europe’s banks, specifically Deutsche Bank, UBS, Credit Suisse and BNP. The recent collapse of Portuguese bank Banco Espirito Santo may be just the tip of the iceberg.

A central banker on one panel noted that, in his view, too much is being asked of monetary policy; the main thing that low interest rates and quantitative easing are producing at the moment is more risk taking by financial institutions.

That’s the problem with too much debt: the only easy solution is more debt, which is no solution at all.